SOUTHWEST AIRLINES CO quarterly report, Q3 FY2012

Southwest Airlines Co. — Q3 2012 Form 10-Q

Reporting period: Quarter and nine months ended September 30, 2012. Unaudited consolidated results include AirTran from its May 2, 2011 acquisition date; consequently, year-to-date comparisons are not fully like-for-like.

Financial results

Metric	Q3 2012	Q3 2011	Nine months 2012	Nine months 2011
Operating revenue	$4.309B	$4.311B	$12.915B	$11.550B
Operating income	$51M	$225M	$532M	$546M
Net income (loss)	$16M	$(140)M	$343M	$26M
Diluted EPS	$0.02	$(0.18)	$0.45	$0.03
Operating cash flow	$464M	$(218)M	$1.833B	$985M

Q3 operating margin was approximately 1.2%, down from 5.2% a year earlier; nine-month operating margin was approximately 4.1%, versus 4.7%. Q3 revenue was essentially flat while operating expenses rose 4.2%. Operating expenses per available seat mile (ASM) increased 5.0%; excluding fuel and special items, unit costs rose 5.8%. Nine-month unit costs rose 3.7%.

Reported Q3 net income improved from the prior-year loss, but this comparison was substantially affected by fuel-derivative accounting: other gains/losses moved from a $405M loss in Q3 2011 to a $10M gain in Q3 2012. Management’s non-GAAP net income was $97M, down 20.5% from $122M; diluted non-GAAP EPS was $0.13 versus $0.15. For nine months, non-GAAP net income rose 33.8% to $352M, with diluted non-GAAP EPS of $0.46 versus $0.34. These company-defined non-GAAP measures exclude specified fuel-hedge effects and special items and are not GAAP substitutes.

Cash, debt and liquidity

• At September 30, cash and cash equivalents were $1.168B and short-term investments were $2.067B, totaling approximately $3.235B. Current assets were $4.652B and current liabilities $4.969B.
• Long-term debt, including current maturities, was approximately $3.226B, down from $3.751B at December 31, 2011. The company repaid $517M of debt and capital-lease obligations in the first nine months.
• Nine-month capital spending for property and equipment was $949M. Financing cash outflows included $325M of share repurchases and $22M of dividends. Cash and cash equivalents increased $339M from year-end.
• Management cited $3.2B of unrestricted cash and short-term investments and an available, unsecured $800M revolving credit facility expiring in April 2016 as liquidity sources.

Material changes and operating developments

• Q3 passenger revenue increased 0.3%; load factor was 82.1%, up 0.1 percentage point. Passenger yield rose 0.8%, while average fare was nearly flat. Nine-month passenger revenue growth reflected higher yields and the full-period inclusion of AirTran.
• Q3 fuel expense fell 3.7%, helped by 2.4% lower fuel consumption and improved fleet efficiency. Nine-month average fuel cost rose 3.2% to $3.27 per gallon, including hedging effects.
• AirTran acquisition and integration costs were $145M in Q3 and $168M year to date. The Q3 amount included a $137M charge tied to the planned lease/sublease of AirTran’s 88 Boeing 717s to Delta.
• Changes in estimates for older 737-300 and 737-500 aircraft increased depreciation expense by about $28M year to date from accelerated retirement assumptions and $20M in Q3 from reduced estimated residual values. The Q3 residual-value change reduced EPS by about $0.01.
• Southwest agreed to defer 30 Boeing deliveries originally scheduled for 2013–2014 to 2017–2018, reducing expected capital expenditures by about $1B over 2012–2014 without reducing total purchase commitments. The company guaranteed principal and interest on $456M of bonds issued for the Love Field modernization project; $304M of project costs and a corresponding obligation were recorded at quarter end.

Outlook, risks and contingencies

• Based on October trends, management expected a solid year-over-year increase in Q4 operating unit revenue. It expected Q4 unit costs excluding fuel, profitsharing and special items to rise approximately 6% year over year; full-year 2012 effective tax rate was projected at approximately 38%–40%.
• Management continued to target $400M of annual pretax AirTran synergies in 2013, excluding acquisition and integration costs, and expected total acquisition/integration costs of approximately $550M; about 55% had been recorded through September 30.
• The company expected 2012 ASMs to approximate combined Southwest and AirTran 2011 levels and did not expect overall fleet growth in 2012. It planned to transition the 717 fleet to Delta beginning in August 2013, at approximately three aircraft per month.
• Fuel hedges expose results and liquidity to commodity-price movements, hedge-accounting volatility, basis risk between WTI and jet fuel, and counterparty credit risk. The company estimated that a 25% fall in relevant commodity prices from September 30 levels could require an additional $512M cash collateral, plus $120M of aircraft collateral and $31M of letters of credit, while lower market fuel prices would provide an operating benefit.
• Two maintenance-vendor contracts associated with the 717 fleet had stated termination penalties totaling approximately $106M; the contracts had not been terminated, and no such charge was recorded. A consolidated antitrust class action involving AirTran and Delta remained pending; management did not expect ongoing legal matters, including IRS examinations, to materially adversely affect the company.
• Management said there were no material changes to the risk factors in its 2011 Form 10-K. It cautioned that economic conditions, fuel prices, competition, AirTran integration and synergy delivery, technology implementation, regulation and third-party dependencies could affect results. Disclosure controls were assessed as effective, with no material quarterly change in internal control over financial reporting.

Important facts for investors to verify

• How much of reported earnings and period-to-period change reflects fuel-derivative marks versus underlying cash fuel costs; compare GAAP results with the company’s non-GAAP reconciliations.
• Whether Q4 revenue improvement and the forecast unit-cost increase materialize, and how these trends affect operating margin.
• Actual remaining AirTran integration costs, realization and timing of the targeted $400M synergy plan, and any further costs or obligations from the 717 transition.
• Fuel-hedge coverage, future settlement costs, collateral requirements and counterparty exposure as market prices change.
• Aircraft delivery commitments, Love Field project guarantees and funding, and any changes in capital spending, debt, or share repurchases.
• Developments in the antitrust litigation and any maintenance-contract termination charges related to the 717 fleet.